Relevant Cost Decisions

DECISION MAKING IN THE SHORT TERM

Decisions
A decision model is a formal method of making a choice, often involving both quantitative and qualitative analyses

A relevant cost is a cost that differs between alternatives.

Five-Step Decision-Making Process

Relevance
Relevant Information has two characteristics:
 It occurs in the future  It differs among the alternative courses of action

Relevant Costs expected future costs Relevant Revenues expected future revenues
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Identifying Relevant Costs

Costs that can be eliminated (in whole or in part) by choosing one alternative over another are avoidable costs. Avoidable costs are relevant costs. Unavoidable costs are never relevant and include:
Sunk costs. Future costs that do not differ between the alternatives.

Identifying Relevant Costs

gather all costs associated with the alternatives eliminate all sunk costs Eliminate all future costs that dont differ between alternatives left are the avoidable costs

Irrelevance
Historical costs are past costs that are irrelevant to decision making
 Also called Sunk Costs- cost that has already been incurred and that cannot be avoided regardless of what a manager decides to do

Types of Information
Quantitative factors are outcomes that can be measured in numerical terms Qualitative factors are outcomes that are difficult to measure accurately in numerical terms, such as satisfaction
 Are just as important as quantitative factors even though they are difficult to measure
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Terminology
Incremental Cost the additional total cost incurred for an activity Differential Cost the difference in total cost between two alternatives Incremental Revenue the additional total revenue from an activity Differential Revenue the difference in total revenue between two alternatives
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Types of Decisions
One-Time-Only Special Orders Insourcing vs. Outsourcing Make or Buy Product-Mix Customer Profitability Branch / Segment: Adding or Discontinuing Equipment Replacement
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One-Time-Only Special Orders

Accepting or rejecting special orders when there is idle production capacity and the special orders have no longrun implications Decision Rule: does the special order generate additional operating income?
 Yes accept  No reject
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One-Time-Only Special Orders

Compares relevant revenues and relevant costs to determine profitability

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Special Orders
Acki Company receives a one-time order that is not considered part of its normal ongoing business. Acki Company only produces one type of silver key chain with a unit variable cost of TL 16. Normal selling price is TL 40 per unit. A company in KKTC offers to purchase 3,000 units for TL 20 per unit. Annual capacity is 10,000 units, and annual fixed costs total TL78,000, but Acki company is currently producing and selling only 5,000 units.

Should Acki accept the offer?

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Special Orders
Acki Company Contribution Income Statement Revenue ( , TL4 ) TL . Variable costs: Direct materials TL4 . Direct labor 1 . Manufacturing overhead . Marketing costs 1 . Total variable costs . Contribution margin 1 . Fixed costs: Manufacturing overhead TL . Marketing costs . Total fixed costs 1 . Net income TL1 .
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Special Orders
If Acki accepts the offer, net income will increase by TL 12.000.

1 1

U h Sp Ch ng

n m n pp h: d n b n m g n = TL20 TL 1 = TL 4 n n m = TL 4 3,000 n s = TL 12.000.

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Potential Problems with Relevant-Cost Analysis

Avoid incorrect general assumptions about information, especially:
 All variable costs are relevant and all fixed costs are irrelevant  There are notable exceptions for both costs

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Potential Problems with Relevant-Cost Analysis

Problems with using unit-cost data:
 Including irrelevant costs in error  Using the same unit-cost with different output levels
Fixed costs per unit change with different levels of output

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Avoiding Potential Problems with Relevant-Cost Analysis

Focus on Total Revenues and Total Costs, not their per-unit equivalents Continually evaluate data to ensure that they meet the requirements of relevant information

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Insourcing vs. Outsourcing

Insourcing producing goods or services within an organization Outsourcing purchasing goods or services from outside vendors Also called the Make or Buy decision Decision Rule: Select the option that will provide the firm with the lowest cost, and therefore the highest profit.

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Qualitative Factors
Nonquantitative factors may be extremely important in an evaluation process, yet do not show up directly in calculations:
   

Quality Requirements Reputation of Outsourcer Employee Morale Logistical Considerations distance from plant, etc.
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Opportunity Costs
Opportunity Cost is the contribution to operating income that is forgone by not using a limited resource in its next-best alternative use  How much profit did the firm lose out on by not selecting this alternative?  The economic benefits that are foregone as a result of pursuing some course of action. Opportunity costs are not actual dollar outlays and are not recorded in the accounts of an organization. Special type of Opportunity Cost: Holding Cost for Inventory. Funds tied up in inventory are not available for investment elsewhere

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The Make or Buy Decision

A decision concerning whether an item should be produced internally or purchased from an outside supplier is called a make or buy decision.

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The Make or Buy Decision

MA Company is thinking of buying a part that is currently used in one of its products from outside. The unit cost to make this part is:
Direct materials Direct labor Variable overhead Depreciation of special equip. Supervisor's salary General factory overhead Total cost per unit TL/ u 27 15 3 9 6 30 90

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The Make or Buy Decision

General factory overhead is allocated on the basis of direct labor hours and is not going to change if the parts are bought from outside. The 90TL unit cost is based on 20,000 parts produced each year. An outside supplier has offered to provide the 20,000 parts at a cost of 70TL per part.

Should we accept the suppliers offer?

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The Make or Buy Decision

Sunk Cost
O e c a e ce
Pe U

ake 70 27 15 3 9 6 30 90 540 000 300 000 60 000 0 120 000 0 1 020 000

20 000 U B y 1 400 000

ec ae a ec a a a e ve ea e ec a eq e v ' aa y Ge e a ac y ve a c

ea

1 400 000

Not avoidable and is irrelevant. If the product is dropped, it will be reallocated to other products.
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The Make or Buy Decision

DECISION RULE In deciding whether to accept the outside suppliers offer, MA isolated the relevant eliminating: costs of making the part by eliminating
 The sunk costs.  The future costs that will not differ between making or buying the parts.

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Product-Mix Decisions
The decisions made by a company about which products to sell and in what quantities Decision Rule (with a constraint): choose the product that produces the highest contribution margin per unit of the constraining resource

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Utilization of a Constrained Resource

Firms often face the problem of deciding how to best utilize a constrained resource. Usually, fixed costs are not affected by this particular decision, so management can focus on maximizing total contribution margin.
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Utilization of a Constrained Resource

UM Company produces two products and selected data is shown below:
2 TL50 35 TL15 2.200 30% 0,50 min.

Less variable expenses per unit Contribution margin per unit Current demand per week (units) Contribution margin ratio Processing time required on machine A1 per unit

36 TL24 2.000 40% 1,00 min.

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Utilization of a Constrained Resource

Machine A1 is the constrained resource. There is excess capacity on all other machines. Machine A1 is being used at 100% of its capacity, and has a capacity of 2,400 minutes per week.

Should UM focus its efforts on Product 1 or 2?

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Utilization of a Constrained Resource

Lets calculate the contribution margin per unit of the constrained resource, machine A1.
Product Contribution margin per unit Time required to produce one unit Contribution margin per minute 1 TL24 1,00 min. TL24 min. 2 TL15 0,50 min. TL30 min.

roduct 2 hould e e pha ized. Provides more valuable use of the constrained resource machine A1, yielding a contribution margin of TL 30 per minute as opposed to TL 24 for Product 1.
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Utilization of a Constrained Resource

Lets calculate the contribution margin per unit of the scarce resource, machine A1. Lets see how this plan would work.
Product 1 o tri utio argi per u it Time required to produce one unit Contribution margin per minute 2 1,00 min. TL24 min. 2 TL15 0,50 min. TL30 min.

f there are o other co ideratio the e t pla would e to produce to eet curre t de a d for Product 2 a d the u e re ai i g capacity to ake Product 1

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Utilization of a Constrained Resource

Lets see how this plan would work.

W q q

3 q 3

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Utilization of a Constrained Resource

According to the plan, we will produce 2,200 units of Product 2 and 1,300 of Product 1. Our contribution margin looks like this.

P odu on nd (un ) n bu on m g n p un o on bu on m g n

du 3 L 4 L3

P odu L L33

n bu on m g n f

L 64
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Managing Constraints
i di g way to proce ore u it through a re ource ottle eck

Produce o ly e old what ca

At the ottle eck it elf: I pro e the proce Add o erti e or a other hift Hire ew worker or ac uired ore achi e Su co tract productio

Eli i ate wa te Strea li e productio proce

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Adding or Dropping Customers

Decision Rule: Does adding or dropping a customer add operating income to the firm?
 Yes add or dont drop  No drop or dont add

Decision is based on profitability of the customer, not how much revenue a customer generates
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Adding or Discontinuing Branches or Segments

Decision Rule: Does adding or discontinuing a branch or segment add operating income to the firm?
 Yes add or dont discontinue  No discontinue or dont add

Decision is based on profitability of the branch or segment, not how much revenue the branch or segment generates
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Adding/Dropping Segments
Income Statement for 2007

8 -

Should the co pa y drop digital i tru e t di i io ? 8

General Factory Overhead and General Administrative Expenses are unavoidable costs.
A u e that the e uip e t u ed i alter ati e u e a ufacturi g digital i tru e t ha o re ale alue or
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Incremental Approach
DECISION RULE UM should drop the digital instruments division only if the avoided fixed costs of the division exceed lost contribution margin of this division.

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Incremental Approach

00 000 0 000 00 000 40 000

0 000 0 000

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Comparative Income Approach

Prepare comparative income statements showing results with and without the digital instruments division.

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24

24

2 4 2 2 2 4

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Joint Product Costs

In some industries, a number of end products are produced from a single raw material input. Two or more products produced from a common input are called joint products products. The point in the manufacturing process where each joint product can be recognized as a separate product is splitpoint. called the split-off point
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Joint Products
Joi t Co t
Joint Input Common Production Process Oil

Gasoline

Chemicals

SplitSplit- ff Poi t
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Joint Products
Joi t Co t
Common Production Process Oil Separate Processing Final Sale

Joint Input

Gasoline

Final Sale

Chemicals

Separate Processing

Final Sale

SplitSplit- ff Poi t

Separate Product Co t
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The Pitfalls of Allocation of Joint Costs

Joint costs are really common costs incurred to simultaneously produce a variety of end products. Joint costs are often allocated to end products on the basis of the relative sales value of each product or on some other basis.

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Sell or Process Further

Decision Rule:  It will always profitable to continue processing a joint product after the split-off point so long as the incremental revenue exceeds the incremental processing costs incurred after the split-off point.

Lets look at the Kere example.

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Sell or Process Further

Kere Company cuts logs from which unfinished lumber and sawdust are the immediate joint products. Unfinished lumber is sold as is or processed further into finished lumber. Sawdust can also be sold as is to gardening wholesalers or processed further into ready-logs.

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Sell or Process Further

Data about Keres joint products includes:

w 4 4

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Sell or Process Further

0 0 0 50 0

50 0 0 0 0

K ?
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Behavioral Implications
Despite the quantitative nature of some aspects of decision making, not all managers will choose the best alternative for the firm Managers could engage in selfserving behavior such as delaying needed equipment maintenance in order to meet their personal profitability quotas for bonus consideration
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